Auditors' reports - the changes are coming

By Liz Stamford FCA

Later this month, consultation on the IAASB’s auditor reporting ED will close. The ED proposes some major changes to the auditor’s report and is the next step in the move to improve auditor reporting following last year’s IAASB invitation to comment (ITC) entitled Improving the Auditor’s Report. The feedback received by the Institute to the ITC was discussed in A new look audit report – the response (Charter, November 2012, p51).

Summary of proposed changes

As expected, the proposals in the ED continue to generate discussion and controversy in the market. Nearly everyone accepts the need for the auditor’s report to change and respond to the needs of users of financial reports but there is still disagreement about how best to serve those needs, and whether the proposals will achieve this aim.

The ED proposals include adding text to the auditor’s report to:

Disclose ‘key audit matters’. The auditor will determine which of the matters communicated to those charged with governance during the audit are ‘key audit matters’. The requirement is principles-based, and the auditor has to take into account areas of ‘significant auditor attention’ during the audit. This requirement applies to listed entities but may be extended by local law or regulation to unlisted entities.

Make explicit statements on the appropriateness of the use of the going concern assumption in the financial report. This is for all audits.

Make an explicit statement on the auditor’s independence.

Other proposed changes include plainer language explanations of the responsibilities of the auditor and those charged with governance, inclusion of the auditor’s name (which is already required in Australia), and communication of significant risks identified by the auditor to those charged with governance.

Reasons for change

The proposed changes are designed to primarily benefit investors, analysts and other users of financial reports. The key deliverable of the audit, from the perspective of the users of the financial report, is the audit report. The IAASB believes that improving the format of the auditor’s report may positively impact users’ perceptions of audit quality. Improved perception of audit quality may also positively impact the user’s confidence in the financial report.

During the course of the audit, the auditor gains insights and knowledge of the company and its operations, which the users of the financial report do not have access to. The current proposals accept the principle that the auditor should not be providing original information about the entity, but recognise that there are options for reporting the work on key aspects of the audit process.

International implications

Other regulators besides the IAASB are moving to expand the auditor’s report and, therefore, the auditor’s responsibilities. In June, the United Kingdom’s Financial Reporting Council (FRC) amended its auditor reporting standard to include requirements for the auditor to provide an overview of the audit scope, describe key risks that impacted the audit strategy and how the audit was performed and explain how materiality was applied. These changes complement changes made in October 2012 to require audit committees to report to the board, for the work of the audit committee to be described in the annual report (including significant matters they considered in relation to the financial statements and how these were addressed) and for the auditor to report if the annual report disclosures do not address matters communicated by them to the audit committee.

In August this year, the US Public Company Accounting Oversight Board (PCAOB) also issued proposed changes to US Auditing Standards on Auditor Reporting and the Auditor’s Responsibilities regarding Other Information. The proposals to change the auditor reporting standard include:

Communication of ‘critical audit matters’ as determined by the auditor. Such matters relate to areas of significant judgment, areas where obtaining sufficient audit evidence is difficult and areas which significantly impact the audit opinion.

The addition of new elements into the report related to auditor independence, auditor tenure, and the auditor’s responsibilities for, and the results of, evaluating other information outside the financial statements

Enhancements to existing language in the auditor’s report related to the auditor’s responsibilities for fraud and notes to the financial statements.

The proposed changes to the Other Information standard describe new procedures the auditor would be required to perform on information outside the financial statements. This will include selected financial data and management’s discussion and analysis. Previously, auditors were only required to read and consider this information, with no reporting requirements. The US proposals are open for comment until 4 December.

Impact in Australia

In Australia, there has been much debate on the proposals and valuable input into the IAASB consultations. This is important because, in line with regulatory objectives, there would generally need to be a compelling reason for the Australian Auditing and Assurance Standards Board (AUASB) to depart from final IAASB requirements. While in Australia, changes such as naming the auditor and including an explicit statement on independence are common practice and not controversial, there are still a number of different views on the two main proposals in relation to going concern and key audit matters.

Going concern

Under the current ISAs, the auditor’s report includes commentary on going concern only if there is a material uncertainty which may or may not be appropriately disclosed or when use of the going concern assumption is inappropriate. Under the new proposals all auditors’ reports will contain a statement that the use of the going concern assumption is appropriate, modified as necessary where there are material uncertainties or other issues. There has been some concern expressed about user confusion. Currently it is argued that a user knows that if going concern is mentioned in the auditor’s report, there is, at least, a material uncertainty that they should pay attention to. Under the new proposals, there is a risk that users will become used to seeing a going concern paragraph and fail to notice when the auditor’s report is flagging an issue with going concern.

Key audit matters

The proposals for the auditor to comment on key audit matters continue to raise challenges but are recognised as more valid than the previous ITC proposals for auditor commentary.

Challenges raised during the consultation process include the following:

Whether there has been a clear articulation of user needs and what specific issues the proposals are trying to address. There have been views expressed that the ‘real’ issue is the complexity of financial reports and the fact that users struggle to understand the issues being communicated by the company in the financial report. This issue, it is believed, should be addressed via simplification of the disclosure requirements in the accounting standards.

Whether the auditor’s report is the right vehicle if there is a demand for different information about the entity and its risks. This demand, it is argued, should be met by audit committee or board communication, for example via integrated reporting or further operating and financial review style commentary.

Whether it is useful to increase the length of the auditor’s report when financial reports are already long and complex.

Whether it is realistic or possible to summarise complex risk areas to a paragraph or two in the auditor’s report.

Whether the text will become ‘boilerplate’ and lose meaning over time.

Whether users have the ability to interpret changes in the key audit matters reported or the number of key audit matters reported.

Whether the spirit of transparency behind the proposals can survive regulatory or legal scrutiny and hindsight. Regulators in different jurisdictions may interpret the requirements differently and even issue guidance on what they expect to see that goes over and above the spirit of the requirements. This would further increase the level of documentation required on audit files to support decisions on what constitutes a ‘key audit matter’. At what point does the cost outweigh any benefit?

Other commentators in the consultation, however, highlighted the value to companies of having the auditor emphasise tricky areas and reporting that these have been dealt with approriately by the company.

The way ahead

While there is no doubt there are plenty of challenges to implement the proposals constructively, the fact remains that the current audit report does not seem to be addressing today’s demands. Users are dealing with increasing complexity in financial reporting and the companies they are investing in. Auditors have unique insights into these matters. The IAASB proposals provide the opportunity for the audit profession to show a little more of the value they bring to the reporting process. The challenges in responding to the calls for change come from balancing maintaining the useability of the report, the value of the information provided and the responsibilities of those charged with governance and the auditor. As with any change, there will be teething issues and the way ahead will be interesting. However the first step needs to be made to maintain audit relevance.

The Institute will be making a submission to the IAASB on their ED. Comments for consideration can be emailed to techsubmissions@charteredaccountants.com.au by 14 November.